Tutorial 4
Expected Utility Theory
- Expect that individuals act rationally by making decisions that maximise their expected utility
- Utility function and expected utility
Prospect theory (tutorial 2)
- Standard expected utility can not account for
- People value perceived gains and losses differently
Key Aspects
- sometimes seek risk aversion and risk seeking, depending on the nature of the prospect
- Different risk preference
- Valuations prospects depend on gains and losses relative to a reference point
- People are averse to losses because losses loom larger than gains
- Weight functions replace the probability ones
Week 2 Challenges to market Efficiency
- Market efficiency is a situation where the prices of securities reflect all available information at any given time
EMH assume that all investors
- Have costless access to currently available information about the future
- They are rational
- They adjust their expectations instantly to reflect new information
- Believe the stock will always trade at the fairest value
- Investor rational, trading activities is always rational
- Error is uncorrelated
- unlimited arbitrage - prices have the potential to diverge from value because errors are often one sided, arbitrageurs will notice such opportunities and swiftly trade for profit in the market
Week 3
- Information asymmetry
- Know stock price is going to increase, insiders can buy at arbitrage profit
- Stock price should reflect insider information
- Behavioural biases
- People always going to follow other positions
- Believe their own knowledge or positions
- Analyses have seen that internet companies are overvalued, should know by the stock
- Internet firms in dotcom bubble lead to price distortion
- Herding behaviour drive up/down prices, challenges to market efficiency
- Market manipulation
- Managers of companies
- Lead to incorrect prices, make the firm look too good
Q5
- Utility theory -
- Risk seekers High risk high return
- risk averse - diversified portfolio